It is often said that the market dislikes uncertainty, and the market has had to deal with a lot of uncertainty so far in 2016. It began with the Deutsche Bank turmoil that led to a decline into the February 11th low and then the Brexit event that shocked the markets and led to a brief two day decline. The market has been resilient and quickly recovered from both of those events. Now, however, Deutsche Bank is back in the news and facing a potential fine of $14 billion imposed by the U.S. Department of Justice. That news has put the health of the entire financial system into question with many suggesting that we are at another “Lehman moment.” That remains to be seen and while Deutsche Bank has come under stress, there is little evidence of stress leaking into the broader market as risk assets remain well bid for, high yield credit spreads continue to contract, and there has not been a renewed flight to safety into U.S. Treasury bonds.
The Fixed Income Total Return strategy allocated 100% of the portfolio to high yield bonds on February 29th, and remained fully committed to high yield bonds through the quarter. For the quarter, the Fixed Income Total Return strategy gained 4.35% (3.58% net). The Barclays High Yield Bond Index gained 5.55% and the Barclays Aggregate Bond Index was up a modest 0.46%. Year to date the Fixed Income Total Return strategy has gained 16.39% (13.84% net) and the Barclays High Yield and Aggregate Bond Indices have gained 15.11% and 5.80% respectively. High yield bonds performed very well during the third quarter as risk assets rallied coming off of the Brexit induced low and credit spreads contracted.
High yield bonds have rallied for eight straight months against a supportive technical backdrop, an accommodative Fed, and a continuation of moderate but uninspiring economic growth. The credit spread contraction theme has been the place to be as spreads (high yield — 10-year Treasury) declined from 581 bps at the end of the second quarter to 458 bps at the end of the third quarter. Even so, the 458 bps spread suggests to us that high yield bonds are not overly expensive as an asset class given historical precedent. For example, the long-term mean spread is 500 bps. In addition, credit spreads peaked at 840 bps on February 11th, which was very high for non-recession periods. The only times in which high yield bonds as an asset class traded at a higher spread to U.S. Treasuries was in the recession of 1990, the early 2000s, and the 2008-2009 credit crisis. Further, the only time that high yield spreads came close to the same level as February 11th in a non-recessionary environment was during the U.S. debt downgrade in 2011. Following that, peak spreads contracted for nearly three years.
We remain constructive on high yield and favor credit over duration. We expect the economy to grow through yearend and therefore remain supportive of credit. However, there are a number of growing risks including the Deutsche Bank situation, the U.S. presidential election, and the Federal Reserve’s timing of additional interest rate hikes. The market has become a little more volatile as the election polls have tightened, but history has shown that is normal in election years. We do expect the Federal Reserve to hike rates at their December 14th FOMC meeting and we think that is likely to lead to more volatility. However, absent an exogenous shock, we expect the yield advantage of high yield corporate debt to be too much for investors to pass on.
Past performance is not indicative of future results.
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The opinions expressed are those of Clark Capital Management Group Investment Team. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. There is no guarantee of the future performance of any Clark Capital investments portfolio. Material presented has been derived from sources considered to be reliable, but the accuracy and completeness cannot be guaranteed. Nothing herein should be construed as a solicitation, recommendation or an offer to buy, sell or hold any securities, other investments or to adopt any investment strategy or strategies. For educational use only. This information is not intended to serve as investment advice. This material is not intended to be relied upon as a forecast or research. The investment or strategy discussed may not be suitable for all investors. Investors must make their own decisions based on their specific investment objectives and financial circumstances. Past performance does not guarantee future results.
The S&P 500 measures the performance of the 500 leading companies in leading industries of the U.S. economy, capturing 75% of U.S. equities.
The Dow Jones Industrial Average is a stock market index that shows how 30 large publicly owned companies based in the U.S. have traded during a standard trading session in the stock market.
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